About Nick: i am an economist based in malaysia. I write about development economics, while sneaking in a pop culture reference or two.

Improving Productivity is Meaningless without the “Why”

Published in The Edge Malaysia, 2 - 8 January 2017, as "Improving Productivity is Meaningless without Understanding the Reason “Why”".

A 500 millilitre bottle of mineral water from a convenience store in Kuala Lumpur costs about RM2. A similar bottle costs, to my great consternation, about RM16 in Oslo, Norway. Sure, the higher price could reflect a much higher quality of water – the Norwegian bottled water (and tap water) does taste better than the Malaysian one, but eight times better?

The more likely reason that bottled water costs RM16 in Norway compared to RM2 in Malaysia is explained by a concept called the Balassa-Samuelson effect. The Balassa-Samuelson effect makes the observation that price levels in richer countries are systematically higher than in poorer ones. As such, bottled water in Norway is far more expensive than in Malaysia because Norway is, on a per capita basis, much richer than Malaysia.

The logic for the Balassa-Samuelson effect is fairly intuitive. Rich countries tend to become rich due to decades of high productivity growth. High productivity growth in turn drives higher wage growth, especially in the tradable exports sector. This is how countries typically grow rich over time – by being excellent at exports, rather than reducing imports, a lesson that Latin America learned painfully in the 1980s.

Now, if wages were higher in the tradable sector, then workers would tend to flock to those sectors. To balance the higher wages in the tradable sector, wages would also naturally rise in the non-tradable (typically services) sector to match the wages in the tradable sector. After all, if labour supply is abundant in the tradable sector, but is scarce in the non-tradable, the laws of supply and demand would raise wages in the non-tradable sector. Higher overall wages in all sectors in the economy would lead to higher prices for goods and services. Hence, the prices of non-tradable goods and services – such as locally bottled water – would tend to be much higher in rich nations than in poor nations.

If you believe the Balassa-Samuelson effect – and there are tonnes of empirical evidence demonstrating its predictions – then you must also agree that the question, “Why are some countries richer and some countries poorer?” is strongly linked to productivity growth. This is not controversial. Indeed, nations around the world, including Malaysia, have outlined the need for strong measures to boost productivity growth, believing that that will drive economic growth. However, what exactly is ‘productivity’ and what does it really mean to boost ‘productivity’?

At the micro-level, productivity is straightforward. Entity A is more productive than Entity B when it produces more outputs than Entity B, given the same level of initial inputs. Put another way, Entity A is more productive than Entity B when it can produce the same level of outputs as Entity B, but with lower levels of initial inputs. At the macro-level, however, the definition of productivity in Economics is linked to a very long and still very exciting line of research that tries to understand the empirical determinants of growth.

The literature on the determinants of growth is differentiated by MIT economist Daron Acemoglu into proximate and fundamental causes of economic growth. Studies of proximate causes of growth attempt to measure to what extent economic growth is attributed to standard measures of input – capital, labour, human capital, land – and to Total Factor Productivity (“TFP”). At the macro level, here is how TFP (or productivity) is measured – take your total economic output and subtract from it the various inputs. What is left must be your TFP. In essence, TFP is how well your inputs work together to generate output above and beyond what the individual units of input produce. As such, TFP at the macro level is really nothing more than an arithmetic exercise.

Therefore, when countries try to increase productivity, what they are essentially doing is trying to increase the arithmetic difference between total output and total inputs. Hence, at a macro level, boosting productivity does not really mean anything. Where productivity can really be increased is at the micro level – the firm level, the individual level and the household level. Productivity in automobile manufacturing in the United States was not boosted by state measures, but by Henry Ford inventing the production line system. It is firms, individuals and households that will have to drive productivity growth, by producing more output for the same or lower levels of input.

To be fair to the Malaysian government, they do recognise this. The annual reports by the Malaysian Productivity Corporation do emphasise the need for productivity gains at the firm and human capital levels. In the Eleventh Malaysia Plan, the Government pledges to place a five-year Malaysia Productivity Blueprint. The outline of the Blueprint contains some promising measures at the micro level such as up-skilling and re-skilling programmes, more targeted skills programmes and introducing enterprise-level productivity assessments and targets.

Taking a step back, however, while the government is trying to address this proximate cause of growth, I am still not certain that a link has been drawn between the proximate causes of growth and the fundamental causes of growth. While the accumulation of inputs and TFP do generate growth, we still want to know why different societies choose different accumulation paths. In other words, we want to understand the fundamental causes that determine choices between input allocation and TFP ‘generation.’ After all, what use are solutions, however well-intentioned, if we do not know the causes for why we are not as productive as we would like to be?

The fundamental causes of growth can be summed up in four major groups. The first is ‘luck’ whereby countries that are in principle identical may diverge because small factors lead them to select different growth choices, leading to different equilibria. The second is ‘geography’ where productivity can be affected by elements such as the physical, geographical and ecological environment. The third is ‘culture’ which are beliefs, values and preferences that affect economic behaviour and therefore may lead to different patterns of factor accumulation and productivity. The fourth is ‘institutions’ which are societally-determined rules, regulations, laws, and policies that affect economic incentives to invest in technology, physical and human capital.

The four groups are all major streams of ongoing economic research. My hope for 2017, as is my hope every year, is that the Malaysian government – and other relevant research entities in Malaysia – participate in figuring out where we are vis-à-vis the fundamental causes of growth. If the government seeks to introduce macro-type measures to boost productivity, without understanding the why behind our productivity or lack thereof, then measures introduced may not address underlying problems. For instance, you may want to incentivise paddy planting in the Sahara by providing greater technical training, but that is ultimately futile.

It would be helpful to learn, for instance, what random instances of ‘luck’ – such as a Trump victory in the United States or the Plaza Accord decisions in the 1980s – have really impacted the country; or to what extent have our geography, culture and institutions hindered or aided our productivity. These are important questions that require addressing, even if the answers may be painful. 2017 will be a challenging year – perhaps more so than 2016; we should not shirk from answering these challenging questions as well.

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